Use of Futures Market Ry Index Funds

USE OF FUTURES MARKET RY INDEX FUNDS

Futures markets can be used for creating synthetic index funds. Synthetic index funds created using futures contracts have advantages of simplicity and low costs. The simplicity stems from the fact that index futures automatically track the index. The cost advantages stem from the fact that the costs of establishing and re­balancing the fund are substantially reduced because commissions and bid-ask spreads are lower in the futures markets than in the equity markets.

The Methodology for creating a synthetic index fund is to combine index futures contracts with bank deposits or treasury bills. The index fund uses part of its money as margin on the futures market and the rest is invested at the risk-free rate of return. This Methodology however does require frequent roll-over as futures contracts expire.

Index funds can also use the futures market for the purpose of spreading index sales or purchases over a period of time. Take the case of an index fund which has raised Rs.100 crore from the Market. To reduce the tracking error, this money must be invested in the index immediately. However large trades face large impact costs. What the fund can do is, the moment it receives the subscriptions it can buy index futures. Then gradually over a period of say a month, it an keep acquiring the underlying index stocks. As it is acquires the index stocks, it should unwind its position on the futures market by selling futures to the extent of stock acquired. This should continue till the fund is fully invested in the index.

QUESTIONS & ANSWERS ON CHAPTER TWO

Q. Assume that the base value of a Market capitalization weighted index were 1000 and the base market capitalization were Rs.35000 crore. If the current market capitalization is Rs. 77.000 crore. the index is at 1. 2010